Development Economics Unit 5

Unit Five
5 Multiple Equilibria, Coordination

Failure and Strategies of Economic
Development
.
The Coordination failure models
 Contents
- General coordination failure models
- The Big Push Theory : production decisions by
modern-sector firms are mutually
reinforcing
- Kremer’s O-Ring Theory: the value of upgrading skills
or quality depends on similar upgrading by other
agents
- For example, value of using an operating system,
word-processing program, spreadsheet
program, instant messaging, and other software
or product standard depends on how many
other users also adopt it 2
The general coordination failure models
 What is coordination failure?

- Firms inability to coordinate their choices leads to an
outcome that leaves all firms worse off than could
be the case in some other potential outcome.
- Everyone is better off waiting for someone else to take
the risk of making the first investment.
- The returns to some critical investments depend on
others making similar investments.
- Investments by an investor increase the incentives to
others to make the necessary investments
3
 Underdevelopment is a coordination failure because

despite their potential benefits, needed investments do
not occur and the country becomes mired in a low
level equilibrium (underdevelopment trap).
 Complementarity An action taken by one firm, worker,
or organization that increases the incentives for other
agents to take similar actions.
 Complementarities often involve investments
whose return depends on other investments being
made by other agents.
4
The general coordination Failure Models
 Three main themes of coordination failure models

1. Complementarities among several conditions
are necessary for development
2. Several critical activities must work well at the same
time to launch sustainable development
3. Investments must be made by many firms/investors
for the investment to be profitable for anyone
firm/investor
5
 Example of coordination failure: Specialized

labor skills
- Firms will not invest in a country if the labor skills
the
firms needs are not available in the country
- But workers will not acquire necessary skills if there are
no firms to employ them
- What should be done in this case?
6
 Important role of government in coordination failure

- Government provides complementary investments
as “one-time fix” to launch development
- “Deep Interventions” sometimes necessary to push
economy toward self-sustaining
- Bad policy choices can mire economy in bad
equilibrium
7
Multiple equilibria and coordination failure

 Basic idea: Whether or not a firm can benefit from some
action (like an investment or adoption of new technology)
depends on how many other investors are expected to
also take the same action or on the extent of those actions.
- Economy can be stuck in a low level equilibrium because
no
one (or not enough) is willing to take the risk of going
first.
- A higher level of development can be reached only if
everyone works together (coordinates) to get there.
- No one finds it profitable to go first because the capital costs
and associated risks of going it alone are too high for the
benefits that can be captured. 8
The general Coordination Failure Models
Multiple Equilibrium Example : New Technology Investment
9
The Big Push models
 The BIG Coordination - Presence of market

failures can lead to a need for public policy to jump
start the process of development (the “Big Push”)
 Does not explain what the “Push” is, how much is
needed, or by whom – just that it is needed.
 Big Push needed at point A in previous graph.
10
The Big Push models
Other Cases Where a BIG PUSH May Be Needed

1. Intertemporal Effects
- Investments take time to yield benefits.
- When investment finally yielding results, other firms
enter and take away some of the revenues with less risk
and lower cost.
2. Urbanization Effects
- Underinvestment in traditional sector because
expenditures of growing incomes in urban sector from
industrialization concentrated on manufactured
goods
11
The Big Push models
Other Cases Where a BIG PUSH May Be Needed

3. Infrastructure Effects
- Profitability of investments depends on existence of
infrastructure
- But if one firm invests in infrastructure, other firms will
benefit without any cost so no one builds
infrastructure. Free riding !!
4. Training Effects
- Underinvestment in training because if one firm invests
in training workers, other firms can bid trained
workers away because they do not have to pay for the
training costs.
12
Kremer’s O-Ring Theory of Development
 Basic idea: Many activities must be done well together

for any of them to generate high value.
- Helps explain poverty traps and why countries caught
in such traps have such low incomes.
13
Kremer’s O-Ring Theory of Development
Essential Model Features:

1. The higher the skill level of a worker, the higher the
probability that the task will be “successfully
completed.”
2. “Positive Assortative Matching” – workers with
high skills tend to work together and those with low
skills tend to work together.
- Some firms and workers, some sectors, and whole
countries can fall into trap of low skill and
productivity while other escape into higher
productivity.
 O-ring model : the value of upgrading skills or
depends on similar upgrading by other agents.
quality 14
Implications of Kremer s Ring Theory
 Firms tend to employ workers with similar skills.

 Workers performing the same task earn higher wages
in a higher skill firm than in a low skill firm.
 Wages tend to be higher in developed countries than in
less developed countries.
 If workers are able to improve their skills, they will do
so only up to the level of the skills of their fellow workers.
 High-value products will be concentrated in countries
with high-value skills
 Everyone would like to work with the more productive
workers, because if your efforts are multiplied by
those of someone else 15
Implications of Kremer s Ring Theory
 you will be more productive when working with a

more productive person
 Countries can get caught in low-production-
quality
traps.
 Bottlenecks reduce the incentive for workers to invest
in skills by lowering the expected returns to those skills
 The bottlenecks have multiplicative effects across
the economy.
16
Conclusions on models
 Coordination Failure - Coordination failure hinders

development because while there is a high return to
investments, there is a high cost and risk to any one firm
investing until enough others also invest.
- Once a “push” occurs, an economy may be able to move
to a higher equilibrium on its own.
- But governments often do not know what “push” is
needed.
17
Conclusions on models
- These modern models point out clearly that

development is a much more difficult process than
simply increasing the rates of saving and investment.
- Chief limitation of these models: They are long on
analysis and short on practical policy recommendations.
18
Strategies of Economic Development
 Two sources of economic growth in the model:

1. Growth in factor endowments (K and L)
- Balanced growth (K and L grow at same rate)
- Unbalanced growth (only one of the two factors
grows)
2. Technical progress
- Hicksian technical progress: neutral, labor-saving,
capital-saving
19
Factor Growth: Three Cases
1. Balanced growth (both K and L grow at same rate)
 Assuming a constant return to scale (CRTS) production

function means that doubling both K and L doubles
output.
 To get a proportionate increase in output, K and L
must
both increase in that same proportion.
 If w e only double L, output increases by LESS than double.20
Factor Growth (cont’d)
2. Unbalanced growth - L growth only
21
Relationship between factor growth and
economic growth
 Balanced factor growth : When both L & K grow at

same rate, then K/L and productivity of K and L remain
the same.
 If dependency burden does not change, then real per
capita income (Q/L) does not change. Note that Q/L =
2Q/2L.
22
Relationship between factor growth and
economic growth
 Unbalanced factor growth: When only L grows, then
K/L decreases and the relative productivity of L
declines. Also, real per capita income declines because
output increases by smaller proportion than L.
 Note that if L doubles, Q will increase by less than
double so Q/L declines.
 When only K grows, then K/L increases and the relative
productivity of K declines.
 Also, real per capita income increases because output
increases while L does not increase.
 If only K doubles, then output increases to some extent
but L does not increase. So Q/L increases.
23
2. Hicksian Technical Progress: Three Types
1. Neutral technical progress: Technical change that increases

the productivity of both K & L in the same proportion
2. Labor-saving technical progress: Technical change that
increases productivity of K but not L.
 Less labor is needed (labor is “saved”) because each unit of
capital is now more productive because of some new
“technology”.
3. Capital-saving technical progress: Technical change that
increases productivity of L but not K.
 Less K is needed (capital is “saved”) because each unit of
labor is now more productive because of some new
“technology”.
24
2. Hicksian Technical Progress: Three Types
25
Cont.…
 Basic argument: Underdevelopment results

from resource allocation due to:
- incorrect pricing policies
- too much government intervention
26
Cont.…
 To improve economic efficiency and

stimulate growth:
- allow free markets to function
- privatize state-owned enterprises
- promote open markets and export expansion
- open doors to foreign investment (FDI)
- eliminate gov't. regulations and pricing policies that
distort markets
27
Cont.…
 DCs are not the cause of LDC problems

- Basic problem: intervention of their own
governments, corruption, lack of economic incentives
- Development is matter of promoting free markets
- Liberalization draws foreign investment and increases
rate of capital accumulation, brings in new
technologies and managerial skills
- Foreign investment works like an increase in savings
28

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Unit Five

5 Multiple Equilibria, Coordination

 What is coordination failure?

 Underdevelopment is a coordination failure because

 Three main themes of coordination failure models

 Example of coordination failure: Specialized

 Important role of government in coordination failure

Multiple equilibria and coordination failure

Multiple Equilibrium Example : New Technology Investment

 The BIG Coordination - Presence of market

Other Cases Where a BIG PUSH May Be Needed

Other Cases Where a BIG PUSH May Be Needed

 Basic idea: Many activities must be done well together

Essential Model Features:

 Firms tend to employ workers with similar skills.

 you will be more productive when working with a

 Coordination Failure - Coordination failure hinders

- These modern models point out clearly that

 Two sources of economic growth in the model:

1. Balanced growth (both K and L grow at same rate)

 Assuming a constant return to scale (CRTS) production

2. Unbalanced growth - L growth only

 Balanced factor growth : When both L & K grow at

1. Neutral technical progress: Technical change that increases

 Basic argument: Underdevelopment results

 To improve economic efficiency and

 DCs are not the cause of LDC problems

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